STREET DOGS: Factor analysis comes of age
From the ‘one-factor’ capital asset pricing model researchers have developed hundreds more and ‘the door is wide open’
From Chicago Booth Review, Factors 101. The original factor — or the forerunner of factor analysis — is, in a sense, the capital asset pricing model (CAPM). Largely developed by Stanford’s William F Sharpe, who was awarded the Nobel Memorial Prize in Economic Sciences in 1990, the CAPM posits that investors are paid for both the time value of their money and the risk they assume in holding an asset. The formula is not reliably predictive. It generates an expected return on assets based in part on the beta of a security, or its covariance with the market … some finance professionals refer to the CAPM as "the one-factor model", where market beta is the sole explanatory factor of expected returns. In 1992, expanding on the CAPM, Chicago Booth’s Eugene F Fama and Dartmouth’s Kenneth R French published a three-factor model, identifying two more things that generate returns: size and value. They observed that small-cap companies outperformed large-cap ones over time, and companies with lo...
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